The Great Stock Myth

Private pensions are heavily regulated to protect workers. But regulation hasn’t stopped the plans from being underfunded, in part because the regulators, who worried that companies would use pensions as a slush fund to smooth their earnings, kept them from overcontributing in flusher times. Even before the latest financial crisis hit, the government-run pension insurer estimated that, on average, plans had less than 90 percent of the assets needed to meet their liabilities. Now those figures are much worse, and workers who have been depending on those pensions may see them slashed if their companies go under and the government takes over their plans.

Even that dire picture may be too optimistic. Allison Schrager, an economist who designs investment strategies for retirement accounts, recently wrote on The Economist’s Web site that for private pension funds, the equity premium “is often assumed to be between 5 percent to 8 percent. In my experience, risk managers go silent when asked where exactly this number comes from.” If the future equity premium turns out to be much lower than these fund managers are projecting, the funding gap may be too large for companies to make up—particularly since the gap tends to be largest in recessions, when companies are least able to find the money for extra contributions.

And yet the private plans are in good shape compared with state and local pension funds. For decades, politicians have promised lavish pension benefits in return for the support of the public-sector unions—promises that they, unlike their counterparts in the private sector, did not have to cover by setting aside a reasonably large asset base. Now the bills are coming due, and many funds are disastrously underfunded. The California state pension system, for example, has only 60 percent of the assets needed to pay its obligations through 2042. With a $19 billion budget deficit, the state is unlikely to be able to make up the shortfall unless the stock market starts zooming again.

California is perhaps the most extreme example, because its state tax revenues depend so heavily on the equity premium. When tech stocks boomed, so did incomes in the tech-heavy state; when they crashed, so did tax revenues. Just like private companies, the state systems were caught in a terrible bind—their revenues were squeezed just when they needed to find more money to shore up their pensions. But unlike private plans, these funds have no pension insurer, and while municipalities can negotiate partial payments in bankruptcy, there is no mechanism for state-operated funds to do so.

Not even the federal government is immune to the market’s gyrations. In the three years after the end of the tech boom, federal tax revenues plummeted from 20 percent of GDP to 16 percent. Many people blame the Bush tax cuts for the entire ensuing budget deficit, but in fact they accounted for less than half of the lost revenue. Most of the change from surplus to deficit came from other factors, most prominently from what the Congressional Budget Office calls “technical” and “economic” change: the government simply collected less revenue during the bust than analysts had anticipated. Wealthy people pay most of the income taxes in America. And their taxable incomes are extremely sensitive to the performance of the stock market—not surprising, considering how many wealthy people either work in finance, or receive compensation in the form of stock options.

For decades, pundits have been warning that a time would come when Social Security would start to become a drain on the federal budget. Now it’s happening. In 2010, for the first time, payouts to retirees and the disabled have exceeded the program’s revenues from payroll taxes. Infusions from the general fund are now needed if the government is to keep mailing checks—a situation that is projected to become a permanent, and growing, problem by 2016.

That means that Social Security, too, is exposed to the performance of the stock market. Unfortunately, unlike the holders of 401(k) accounts, the beneficiaries are not aware of this, which means that they will not, for example, delay retirement until the market recovers. (In fact, Social Security is thought to cause older Americans to retire before they otherwise would.)

Whether Americans know it or not, they have spent decades basing their retirement plans on expectations of big capital gains in their houses and stock portfolios. But no system can completely protect us from the problem of lower asset returns. Schrager suggests that unless we suddenly become willing to save a huge chunk of our income every year, we may need to rethink our retirement plans. “I don’t know if it’s ever going to be realistic that everyone saves enough to spend the last third of their life on vacation,” she says.

That’s all right for economists and journalists, who can probably spend a good bit of their golden years at a desk, typing. But is that realistic, or appealing, for people with less cerebral jobs? Realistic or not, it may be the future for all of us.